A Grantor Trust, Or Not? Answers.

I also challenged you to analyze the facts to determine whether you believed the trust in question to be a grantor trust or a non-grantor trust. I then promised you I’d be back in a few days to let you know if the IRS agrees.

So, here goes . . .

If you determined the trust was a non-grantor trust, consider yourself a Trust Einstein. It is NOT a grantor trust.

But I have a confession to make: I was wrong at first. I’ll explain why below.

The Service recently issued a letter ruling on our facts determining that the trust was NOT a grantor trust. You can look at Private Letter Ruling 201650005 and see for yourself. As with many letter rulings, however, it is somewhat conclusory.

Let me fill in a bit.

Most of the ruling hinges on the status of the various parties other than the grantor, and how much power the Distribution Committee had. One aspect also related to the manner in which the trust agreement circumscribed the grantor’s power to unilaterally act.

Extreme succinctness notwithstanding, the ruling provides a good, brief review of the grantor trust rules and it tracks some of the analysis we use in Module Three at BaseCamp.

Adverse and Nonadverse Parties

First determine who the adverse parties are. All of the members of the Distribution Committee (other than grantor, of course) are adverse parties. In fact, in two of the three potential distribution scenarios, the grantor is completely at the mercy of (or, I guess, on the side with) a majority of Distribution Committee; He can’t act alone (except in distribution scenario three discussed below).

Grantor Trust Powers Analyzed

As we teach at BaseCamp, when analyzing a grantor/non-grantor trust scenario, first determine whether there is a power or right that potentially involves a grantor trust power or right defined in IRC §§ 673-678. If there is, then determine whether it is relevant that an adverse party could block, thwart or hinder the exercise of that power or right.

Section 673

I’ll address IRC § 673 last because, frankly, it stumped me for a bit. We’ll come back to that.

Section 674

Section 674(a) lays out the general rule that a grantor will be treated as a trust owner if she or a nonadverse party can affect the beneficial enjoyment of the trust (or a portion thereof) without the approval of an adverse party. That’s why I call adverse parties party wreckers.

Obviously, under Distribution Scenarios One and Two Gerald Grantor can’t do much of anything without a majority of the Distribution Committee (all adverse) cooperating.

Subsection (b)(3)

Income and principal were potentially “accumulatable” (my term) and, accordingly appointable by Grantor’s will. If income (including capital gains) can be accumulated within the discretion of either grantor or a nonadverse party for later appointment by grantor’s will, IRC § 673(b)(3) will “trigger” grantor trust status, UNLESS the decision to accumulate or not cannot be taken without the consent of an adverse party. That is the case in our fact pattern. So much for subsection (b)(3).

Subsection (b)(5)

The only other IRC § 674 power implicated is IRC § 674(b)(5)(A). READ THIS BECAUSE THIS IS IMPORTANT. It is important because many folks overlook this (as either a trap or an opportunity).

IRC § 674(b)(5)(A) is an exception to IRC § 674(a): Fit within the exception and the power does not constitute a grantor trust. Section 674(b)(5)(A) refers to is a power to distribute corpus to a beneficiary regardless of by whom the power is held (yes, folks, even the grantor) as long as the power is circumscribed by a reasonably definite standard.

Distribution Scenario Three gives Gerald Grantor the authority to direct distributions of principal to any beneficiary other than himself for the “health, maintenance, and support” of the beneficiary. HEMS is a “reasonably definite standard” (actually that standard is a bit broader than the familiar HEMS).

That takes care of IRC § 674. What about IRC § 675?

Section 675

IRC § 675 involves a variety of powers pertaining to administration of the trust. Broadly, all Section 675 powers fall into two categories. In one category if the powers are subject to the cooperation of adverse parties the powers involved will not trigger grantor trust status. In the other category of rules grantor trust status depends entirely upon whether the power was actually triggered and thus depend entirely upon facts and circumstances of trust administration on a tax year-to-tax year basis. The letter ruling specifically says that much of IRC § 675 is “attendant on the operation of the Trust” and any decision would need to be “deferred until” further examination of federal returns.

Sections 676 and 677

Sections 676 (power to revoke) and 677 (income for the benefit of grantor or spouse) are entirely dependent on no adverse party involvement. If an adverse party must consent or cooperate, it is not a grantor trust. Moving right along . . . .

Section 678

I’ve always thought IRC § 678 to be interesting. Read Use IRC Section 678 to Make a Trustee Very Angry. Section 678 is the only section under which someone other than the grantor can be deemed trust owner if she has sole discretion to make a distribution to a class that includes herself. First, the trust must not be a grantor trust with respect to the grantor, and second, the power holder’s discretion must sole. No person in our fact pattern has that authority.

Bob’s Section 673 True Confession

True Confessions Time. I went along with everything described above. I choked on IRC § 673.

Section 673 says that the trust will be a grantor trust if the grantor retains a potential reversionary right that exceeds 5% of the trust value. In determining the value of the potential reversionary interest IRC 673(c) tells us to assume “the maximum exercise of discretion in favor of grantor.”

There. The reversionary interest is worth 100% because under Distribution Scenarios One and Two distributions could be made to Gerald Grantor and if we assumed the Distribution Committee exercises maximum discretion . . . . WRONG!

Two practice pointers:

One, assume the IRS prints nothing irrelevant in the fact pattern of a letter ruling. If it is in there, it is relevant.

Two, RAFTA! RAFTA! RAFTA! (Read All the Friggin’ Trust Agreement).

The fact pattern in the letter ruling says that Article One, Section 3 of the Trust Agreement says, “Grantor’s intentions in creating Trust are, generally, that Trust is a non-grantor trust . . . . [and] that all provisions to this agreement shall be interpreted in such a manner so as to give effect to these intentions. Any power that is contrary to these intentions shall be void.”

In other words, the Service gave effect to self-serving “boilerplate” that we often see. In our case, the power to distribute to grantor under section 673 could not be interpreted to exceed more than 5% of the value of the trust.

Nongrantor Trust But Estate Inclusion

I didn’t analyze why the Service concluded the entire trust would be includible in Gerald Grantor’s estate. But it would be due to any number of reasons Under IRC §§ 2036 and 2038. In any event, the result of that would have been stepped-up basis in the assets on the death of Gerald.

In the elder law context we can think of reasons we’d want a nongrantor trust that insured basis step-up, could we not? Of course we could!

Comments

Would you comment on the fact that the grantor in this ruling had the power to exercise the testamentary power of appointment “by living trust or by will”. In looking at the two 674(b)(3) tests needed for grantor trust status (income accumulatable by grantor, nonadverse, or both and appointable by grantor “only by will”), the requirement that the grantor’s consent be obtained for a distribution to be made (aka a veto power) seems to meet the income accumulatable test. Perhaps allowing an exercise by a living trust flunked the appointable “only by will” test, resulting in non-grantor trust status?

Sal, will vs. testamentary trust had nothing to do with grantor trust status. If the decision to accumulate income could not be made without an adverse party it wouldn’t be a grantor trust even with a power to appoint by will. What they were after with that – and not discussed by me – was they were also after estate inclusion, which the testamentary power would have accomplished even with an adverse party involved. Section 2038 refers to the testator even though she might need the cooperation of “any other party” (which could create estate inclusion without triggering grantor trust status if that “other party” happened to be adverse.

What these folks were probably setting up is a DING (Delaware Intentional Nongrantor trust). With that, they set up a trust in a jurisdiction with no income tax, perhaps in anticipation of avoiding capital gains tax at a state level. If the trust holds an incredibly expensive, highly appreciated asset, the costs of having it taxed for federal purposes in the trust with compressed tax rate brackets might easily out weigh the costs of an additional state tax that could be avoided. I didn’t get into that here because that will likely not be of much interest to an elder or special needs law attorney. The PLR, however, illustrated some concepts of general interest to elder law attorneys trying to decipher grantor trust rules.

About Us

TrustChimp™ is here to help the elder and special needs law bar of the United States make sense of trusts as a planning tool in the context of public benefits such as Medicaid. Discover what we can do for you and who we are. Then sign on. It’s free. Read More…